Author Topic: 401k After-Tax to Roth Conversion  (Read 3860 times)

TLV

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401k After-Tax to Roth Conversion
« on: July 03, 2013, 09:59:49 am »
So I got an email from HR this morning that made me sit up and pay attention.

Previously, they allowed up to 7% of salary to be put into the 401k on an after-tax basis (not Roth). They've increased this to 20k per year, regardless of salary.

I had thought this was basically the same as a taxable account, just with access to the 401k funds (which are pretty good - VIIIX anyone?) However, the wording of the email suggests that they are "deferred" - which I take to mean that they are like non-deductible IRA contributions, so they'd have the same withdrawal limits as the regular 401k contributions, but earnings are taxed as ordinary income upon withdrawal rather than as capital gains/dividends every year. They'd also be eligible for conversion to Roth when the 401k is rolled over to an IRA after leaving my employer.

Are after-tax 401k contributions like regular taxable accounts, or like non-deductible IRA contributions?
Edit: I've find a direct statement in the plan summary that says the earnings are not taxed until distributed for these, so it seems to be like a non-deductible IRA contribution.

The second part of the email is even more important if I'm reading it right. The 401k plan now allows for in-plan Roth conversions - including conversions of the after-tax contributions. There also doesn't seem to be a "proportionality rule" like there is with IRAs - I would be able to convert just the after-tax contributions, without having to convert any pretax money. I also haven't found any limits on it. So it seems like an enhanced back-door Roth, that will let me put an extra 20k per year into Roth accounts. Am I getting this right? What's the catch?
« Last Edit: July 03, 2013, 10:08:36 am by TLV »

Joet

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Re: 401k After-Tax to Roth Conversion
« Reply #1 on: July 03, 2013, 10:54:52 am »
it's a non-deductible IRA contrib most likely (the phaseout for that is around 40-50k of income)

I do this annually. You can contribute a max of $51k to 401k type plans including pretax, match, and post tax. For me that means I aim to have about $26k in post-tax to hit this cap. My plan allows me a 1x annual in-service withdrawl which goes directly to a Roth I have @ fidelity. I'll owe a tiny bit of taxes on the gains for that $26k in the year it sits invested in the plan prior to the withdrawl. Usually not much. A good year is like 5-10% growth at most, so only several hundred bucks of taxes are ever owed it seems on this.

It's a great trick. Then you can also add another $5.5k to the Roth via direct or backdoor method(s)

There is no catch. I have over $100k in my Roth after only 3 years of doing this lol
« Last Edit: July 03, 2013, 10:57:39 am by Joet »

TLV

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Re: 401k After-Tax to Roth Conversion
« Reply #2 on: July 03, 2013, 11:27:22 am »
Thanks for the info, JoeT. That seems to match up with what I'm reading perfectly.

Have you ever had a loss before the conversion? I'd like to know if losses would reduce taxes in the year of the conversion - though that's a minor issue and not one that would change my decision.

The only downsides I can see are those inherent with Roths and 401ks in general - distribution limitations while at this employer, and limitations/penalties on early withdrawal of earnings, both of which are outweighed by the tax advantages.

Joet

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Re: 401k After-Tax to Roth Conversion
« Reply #3 on: July 03, 2013, 11:50:12 am »
contributions are redeemable at any time in your Roth! only the earnings are 'stuck'

There is a provision for re-characterizing the contrib after a loss but I havent really looked into it.

It's difficult to implement via payroll deductions also, more applicable to the non-payroll IRA style. EG contribute $5k for TY2013, say it goes down in value to $3k. Rather than saying 'shoot/FML/etc', you can then withdraw that via a re-characterization, realize the $2k short term loss as a deduction/carryover on your taxes... and contribute another $5k for 2013 again by april filing deadline for the tax year.

*not an accountant/CPA, but have stayed at a holiday inn recently

dan23

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Re: 401k After-Tax to Roth Conversion
« Reply #4 on: July 03, 2013, 05:28:39 pm »
I do this as well and Joet nailed it.  Some funds allow lump sum contributions so you can avoid tax on earning to.  If yours does not you should take full advantage of however many times a year your plan allows in-service non hardship pre 59.5 withdrawals.  You should get the money into your Roth IRA as quickly as possible. 

As for not being able to access the money in a Roth IRA- if you don't have earnings on the money, you may be able to access the rolled over/converted money tax and penalty free immediately if you wanted to (you obviously shouldn't) and even with earnings it only means penalty for 5 years..  See ordering of distributions in this article.
http://fairmark.com/rothira/distrib.htm

I suggest paying tax on earnings using outside money so more hits your Roth (don't have your plan withhold).

I also suggest you just do the full amount in your after tax 401k and pay taxes if earnings are not really high (sounds like you may have none) as methods to avoid taxes on earnings are pretty complicated and mostly questionable for IRS purposes.





TLV

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Re: 401k After-Tax to Roth Conversion
« Reply #5 on: July 04, 2013, 07:55:02 am »
I will definitely take advantage of this for the next couple of years. My projections are showing a distinct likelihood of having nothing left but Roth earnings (and having to pay penalties) by my mid-fifties if I max it every year, so I need to run some more numbers to see if the tax free growth is worth a few years of penalties or if I should stop contributing to Roth at some point to pad the taxable stash.

dan23

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Re: 401k After-Tax to Roth Conversion
« Reply #6 on: July 04, 2013, 08:59:37 am »
Not sure if I understood your last post correctly, but if I did - you should not have an issue where you are forced to withdraw mostly penalty eligible earnings.  This is what you should do 401k related (if you have the money)
1. max out your regular 401k and get the match whatever it is
2. put as much as possible as quickly as possible each year into your after tax 401k (up to 51k- regular 401k contributions-match to a max of in your case 20k)
3. As many times as you are allowed to each year (should be at least once) do an in-service withdrawal of all the after tax 401k money to your Roth IRA
Example - In 2013 you put 20K in your after tax 401k subaccount - by the time you do the inservice withdrawal in 2013 you will have 22K so you will move 22k to your roth ira and pay tax on 2k for 2013 tax year.
4. you will likely be able to withdraw the entire 22k out penalty free and tax free from your roth ira 5 years later (additional earnings on the 22k cannot be withdrawn until you are 59.5).  If you withdraw the 22k earlier than 5 years you will owe 10% penalties on 2k.

Separately (and probably before you do this after tax 401k trick), if you don't have money in a standard IRA (if you do, you can still do this, there is just a bit of prep work first), you should take advantage of a backdoor roth ira (http://thefinancebuff.com/the-backdoor-roth-ira-a-complete-how-to.html) - the entire 5500 you do from this should be withdrawable immediately (provided you don't have other money blocking it).

Basically you should be able to put up to 56,500 in a tax advantaged accounts each year with the entire amount put in Roth IRA each year withdrawable penalty free 5 years after you put it in.

Note, and this is important, that if you cannot do in service pre 59.5 non hardship withdrawals at least once each year from your after tax 401k subaccount - this is no longer a good strategy - this is because for the time the money sits in your after tax 401k subaccount, if it sits there until your retirement and is not moved to roth ira every year - you are trading ltcg tax rate for deferred taxes at ordinary income rate - generally not a good trade.

« Last Edit: July 04, 2013, 09:18:39 am by dan23 »

TLV

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Re: 401k After-Tax to Roth Conversion
« Reply #7 on: July 04, 2013, 11:07:48 am »
You misunderstand me. I'm aware of penalty-free withdrawals on Roth contributions, including on conversions (both pre-tax and after tax). I don't even need to do a backdoor Roth IRA because my income's not quite that high.

The issue I have is that if I max the after-tax 401k -> Roth route every year until FI (combined with maxing 401k and Roth IRA that I'm already doing), there is a significant chance that around age 55 I will have used up all taxable savings AND all Roth contributions (including from 401k rollover/conversions), and be left with literally no money that is not Roth earnings. I would then have to pay income tax + 10% on everything I take out from ~55 until 59 1/2. It may be that 30 years of tax-free growth counters the tax+penalty (especially since it's only ~5 years of expenses) - I'm still running numbers to get a sense of how likely that is, and (if it turns out to not be worth the tax/penalty) what the optimum amounts to add to Roth would be.

It's an interesting problem because it seems I might (*might*) be better off not doing the conversion as often, or delaying 401k conversion after FI, in order to have more money that counts as Roth contributions rather than earnings, even though I may pay more in taxes along the way that way.

dan23

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Re: 401k After-Tax to Roth Conversion
« Reply #8 on: July 04, 2013, 04:19:12 pm »
Got you.  Sorry about that.  If that happens, I believe (not 100% sure) you could do 72t when you hit 55 and pay no tax or penalty.  I would not do after tax 401k and then delay the conversion.

If your choice ends up being between doing this while planning to delay conversion to much later vs not doing this at all and having money in a taxable account instead - if you invest in index funds for the long run or the like, with the exception of long term holdings of bonds, you will possibly/likely be better off in taxable than after tax 401k.  If you plan on trading stocks frequently (and your 401k allows you to), 401k even with delayed conversion could be the better choice.
« Last Edit: July 04, 2013, 04:21:39 pm by dan23 »

Ryan Dagg

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Re: 401k After-Tax to Roth Conversion
« Reply #9 on: July 08, 2013, 06:37:29 pm »
Have you figured out how your plan handles in-plan conversions? They may not allow it before 59.5 or they may only allow it once per 5 years or they may put up any number of other hurdles. Make sure you know before taking action!

Call and ask very specific questions and ask them of at least 5 different reps. Let them know you are recording the call. Most of the reps will be insufficiently trained and more concerned with keeping their average call length below 3 minutes then with helping you.


The issue I have is that if I max the after-tax 401k -> Roth route every year until FI (combined with maxing 401k and Roth IRA that I'm already doing), there is a significant chance that around age 55 I will have used up all taxable savings AND all Roth contributions (including from 401k rollover/conversions), and be left with literally no money that is not Roth earnings. I would then have to pay income tax + 10% on everything I take out from ~55 until 59 1/2.
You would only have to pay the 10% penalty and not income taxes on earnings if you had the Roth account for > 5yrs and were < 59.5. The 5 year rule specifically determines if you owe income taxes on earnings or not. http://en.wikipedia.org/wiki/Roth_IRA#Advantages
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TLV

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Re: 401k After-Tax to Roth Conversion
« Reply #10 on: July 09, 2013, 04:05:28 pm »
Got you.  Sorry about that.  If that happens, I believe (not 100% sure) you could do 72t when you hit 55 and pay no tax or penalty.  I would not do after tax 401k and then delay the conversion.

I didn't know you could 72t Roths, but apparently you can so that's on the table.

Have you figured out how your plan handles in-plan conversions? They may not allow it before 59.5 or they may only allow it once per 5 years or they may put up any number of other hurdles. Make sure you know before taking action!
The HR website explaining the conversions is quite detailed. It can be done once per calendar quarter, must be a direct conversion (as opposed to a distribution to you with 60 days to re-contribute it, or something like that), and it must be done over the phone (no web interface).

Quote
You would only have to pay the 10% penalty and not income taxes on earnings if you had the Roth account for > 5yrs and were < 59.5. The 5 year rule specifically determines if you owe income taxes on earnings or not. http://en.wikipedia.org/wiki/Roth_IRA#Advantages

The Wikipedia article you linked is ambiguous about it as far as I can tell. Based on my reading of the 1040 (line 15), 8606, and 5329 instructions, this is incorrect - early withdrawals on earnings are taxed as ordinary income + 10%. In particular, 5329 (which is used for determining the 10% additional tax) uses the "amount of the distribution that you must include in income" as its basis.

There are two different 5-year rules.

The 5-year rule for conversions applies only to the conversion amount - 5 years after converting, the conversion amount is tax free to withdraw just like a regular contribution, even before age 59 1/2. If you withdraw a conversion amount before the 5 years are up, it's taxed 10% (this is known as a "recapture") - no income tax because it was taxed as income in the year of the conversion.

The other 5 year rule may be the one you were thinking of - your Roth account has to be at least 5 years old before earnings are tax free, even if you're over 59 1/2.  If you wait to contribute to a Roth for the first time until you're 58, you can't get tax-free earnings until 63 (though the 10% penalty doesn't apply after 59 1/2 - only ordinary income tax).

fiveoclockshadow

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Re: 401k After-Tax to Roth Conversion
« Reply #11 on: July 10, 2013, 06:40:48 am »
You would only have to pay the 10% penalty and not income taxes on earnings if you had the Roth account for > 5yrs and were < 59.5. The 5 year rule specifically determines if you owe income taxes on earnings or not. http://en.wikipedia.org/wiki/Roth_IRA#Advantages

The Wikipedia article you linked is ambiguous about it as far as I can tell. Based on my reading of the 1040 (line 15), 8606, and 5329 instructions, this is incorrect - early withdrawals on earnings are taxed as ordinary income + 10%. In particular, 5329 (which is used for determining the 10% additional tax) uses the "amount of the distribution that you must include in income" as its basis.

So I've got the Nolo book on retirement plans right here (recommend you get this from the library, it is excellent).

TLV is correct, he'd be hit with both the 10% penalty and income tax - a bad thing.

This can get confusing because some things provoke just the 10% penalty but no income tax and others trigger both.

Contributions and conversions are *never* subject to income tax on distribution since they were already taxed on the way in.  Conversions can, however, be subject to 10% penalty (5 year since conversion rule applies here).

Qualified distributions of earnings are not subject to income tax, non-qualified are and would also be hit with a 10% penalty.  There are two non-qualified distributions of earnings - anything before 59.5 or anything earlier than five years after you've opened your first Roth IRA (this is the second five year rule).  Note this means you could have a non-qualified distribution even if older than 59.5 because of the second rule.

The language gets confusing because what are and aren't "qualified" and "non-qualified" distributions are nearly identical to the rules for a traditional IRA.  What is different is that many "non-qualified" Roth distributions have no penalty nor any income tax despite being called "non-qualified".  Additionally the order of distributions for Roth is different from traditional and this means that essentially all penalty and tax free distributions are ordered before any penalty/taxable distributions are made.  From a practical stand point the "qualified" and "non-qualified" terms for Roth distributions mostly provoke confusion...

Anyway, I recommend the Nolo book as a good reference.
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Joet

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Re: 401k After-Tax to Roth Conversion
« Reply #12 on: July 10, 2013, 12:33:40 pm »
I still say this falls under the 'good problem to have' category. Things change, you never know. If at the end of the day you were able to maximize your tax advantaged space so effectively that you hit a 10% penalty kicker to some Roth earnings at some point well down the line you've already more than won the game.

There is a certain 'put option' of sorts for prepending your savings with as much tax advantaged stuff early as possible. You never know how the job market will fare for you 10+ years down the road

JasonW

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Re: 401k After-Tax to Roth Conversion
« Reply #13 on: July 11, 2013, 10:12:16 am »
If my MAGI is above the IRS limits for Roth IRA contributions, I assume that the conversion step to the Roth IRA would not be possible, right? If so, is there any advantage to after-tax 401k contributions compared to contributions to my after-tax Fidelity account?

TLV

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Re: 401k After-Tax to Roth Conversion
« Reply #14 on: July 11, 2013, 10:44:29 am »
?
If my MAGI is above the IRS limits for Roth IRA contributions, I assume that the conversion step to the Roth IRA would not be possible, right?
Wrong - as of 2010 (IIRC), there are no income limits on Roth conversions (only contributions).

Look up the "backdoor Roth" strategy - it gets around the Roth income limits for IRAs as well.

Quote
If so, is there any advantage to after-tax 401k contributions compared to contributions to my after-tax Fidelity account?

The after-tax 401k contributions are similar to nondeductible traditional IRA contributions - tax on earnings is postponed until withdrawal, but withdrawals have restrictions/penalties and the taxable part is taxed as income instead of capital gains/dividends.

JasonW

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Re: 401k After-Tax to Roth Conversion
« Reply #15 on: July 11, 2013, 11:05:02 am »
?
If my MAGI is above the IRS limits for Roth IRA contributions, I assume that the conversion step to the Roth IRA would not be possible, right?
Wrong - as of 2010 (IIRC), there are no income limits on Roth conversions (only contributions).

Look up the "backdoor Roth" strategy - it gets around the Roth income limits for IRAs as well.

Ok, I think I understand. Anyone can create a Roth, and make conversions to a Roth, but only those who meet certain requirements, like a MAGI under such and such, can make direct contributions. Usually on these forums when a backdoor Roth is discussed, it's in relation to pending early retirement, and so is done once your income drops. But obviously when using the backdoor for this scenario, I will be hit unavoidable taxes, first on the actual contribution since it's after tax, and then at the same marginal rate on any gains during the year.

TLV

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Re: 401k After-Tax to Roth Conversion
« Reply #16 on: July 11, 2013, 11:28:00 am »
But obviously when using the backdoor for this scenario, I will be hit unavoidable taxes, first on the actual contribution since it's after tax, and then at the same marginal rate on any gains during the year.

Direct Roth contributions are also after tax, so that part is no different for the backdoor. If you are making your contributions over the course of the year and then converting, then yes, you're correct about the gains. If you can make the whole $5500 contribution up front at the beginning of the year, then convert ASAP after that, you can minimize the gains that are subject to that tax rate.